IDC Financial Publishing, Inc. (IDCFP) utilizes the acronym CAMEL to represent the financial ratios used to evaluate the safety and soundness of commercial banks, savings institutions and credit unions. This article explains how IDCFP uses liquidity as a component of its CAMEL ranking system and why it is valuable and important to monitor.

Liquidity risk occurs when an institution’s loan delinquency exceeds 4% of its total loans and its balance sheet cash flow is substantially negative.

Balance sheet cash flow is operating cash flow minus financial cash flow.

• Operating cash flow equals the annual change in retained earnings less the annual change in growth-producing assets.
• The purpose of measuring operating cash flow is to determine an institution’s ability to internally finance the growth of these assets.
• Financial cash flow equals the annual change in liabilities (excluding retained earnings), less the annual change in loans, investments, and other non-cash or equivalent assets.
• Financial cash flow isolates the annual change in sources, and uses, of funds.

Considerably negative balance sheet cash flow occurs if annual changes in retained earnings are negative and/or the annual change in all other liabilities substantially exceeds the annual change in loans and investments. An institution with poor loan quality or risky investments will experience asset write-offs or write-downs. At the same time, an at-risk institution will finance its asset base by relying on deposit increases and new borrowing. The resulting negative balance sheet cash flow threatens the safety and soundness of the financial institution.

Institutions with significant negative balance sheet cash flow as a percent of equity capital, and loan delinquency in excess of 4% of all loans are ranked by IDCFP below 125. Our ratings of banks, savings institutions, and credit unions range from 300 (the top grade attainable) to 1 (the lowest). From the early 1990’s, through today, institutions using our ranks determined that ratings lower than 125 were deemed below investment grade.

A Forecast for the Next Banking Crisis

Out of the 5,589 total commercial banks and savings institutions, IDCFP has identified 1,352 that have outstanding brokered deposits. Using this group of 1,352 institutions, and tracking institutions ranked less than 125 within this group, provides a forecast for the next era of banking problems in 2021.

Table I illustrates this trend when examining these commercial banks and savings institutions ranked less than 125 by IDCFP with our CAMEL analysis.

• The number of institutions reached a low of 55 in the second quarter of 2017.
• The “C” component, or institutions with insufficient Capital fell to a low of 2 in the first quarter of 2018 and increased in the second quarter.
• The “A” component represents institutions lacking Adequacy of capital to cover delinquency with less than 5% risk-adjusted capital. These institutions declined to a low of 5 in the fourth quarter of 2017.
• The “M” component, which uses Margins as a measure of management continues to decline, reaching a low level of 14 in the second quarter of 2018.
• The “E” component represents institutions exhibiting negative Earnings or returns on financial leverage (ROFL). These institutions fell to a low of 17 as early as the third quarter of 2016.
• Finally, the “L” component represents negative Liquidity, or high levels of loan delinquency with negative balance sheet cash flow. This fell to a floor of 0 in the second quarter of 2018.

When examining institutions with outstanding brokered deposits, there is an increase in the number among these ranked less than 125 by IDCFP. The current trend shows the number of these institutions in most components of CAMEL have hit a low and are rising (see Table I). This group of institutions ranked less than 125, and having brokered deposits, points to another potential banking problem in 2021. Similarly, in 2005 and 2006, IDCFP’s CAMEL ranks under 125 of all institutions forecast the 2008 and 2009 banking crisis. (See Table II).

Table I

Early Warning Indicators in History

The number of commercial banks and savings institutions ranked below 125 reached a low in the 2^nd quarter of 2006, two years before the banking crisis in 2008. More importantly, leading up to this point, 4 out of the 5 components of CAMEL also reached lows from the 3^rd quarter of 2005 through the 1^st quarter of 2006, and then began to rise.

As seen in Table II below,

• Commercial banks and savings institutions with insufficient capital reached a low of 47 institutions in the 3^rd quarter of 2006.
• Financial institutions with less than 5% adequacy of capital reached a low count of 29 in the 3^rd quarter of 2005.
• Banks and savings institutions with a lack of profitability, or low and unstable margins, reached a low of 178 in the 4^th quarter of 2005.
• The commercial banks and savings institutions with severe negative earnings due to financial leverage reached their low of 185 in the 4^th quarter of 2005.
• Finally, institutions with high loan delinquency and negative balance sheet cash flow, or negative liquidity, reached their low of 2 in the 1^st quarter of 2006.

All 5 categories of rank, Capital, Adequacy of capital, Margins as a measurement of management, Earnings from operations and financial leverage, and, finally, Liquidity, together provide a timely indication of risk and potential failure. An increase in the number of banks ranked under 125 in all components of CAMEL is required to confidently forecast a future banking crisis.

Table II

As seen in history, the increase in the number of financial institutions with IDCFP’s CAMEL ranks below 125, or below investment grade, forecast the bank financial crisis a few years later. IDCFP’s ranks are critical for investors to monitor financial institutions.

To view our products and services please visit our website at www.idcfp.com . For further information about our CAMEL ranks, or for a copy of this article, please contact us at 800-525-5457 or info@idcfp.com.

John E Rickmeier, CFA, President, jer@idcfp.com

Robin Rickmeier, Marketing Director